Review: The Four Pillars of Investing

I’ve been excited to review this book for a while. I remember the first time I picked it up, in a bookstore early this year. I read almost the entire book over a three hour period while curled up in a chair at the back of the store, only interrupted by my wife calling wondering where on earth I was at with the groceries that she wanted.

So, yes, The Four Pillars of Investing intrigued me quite a bit and got my juices flowing for the first time about investing. It appealed very strongly to my analytical sense, much like A Random Walk Down Wall Street, but unlike that other book, this one attempts to identify the underlying ideas behind sound investing. What “pillars of knowledge” support good investing practice? That’s what William Bernstein attempts to identify in this book.

What excited me so much about this book, and what sets it apart from other books? Let’s walk through the book to find out.

Chapter 1 – No Guts, No Glory
The opening chapter of The Four Pillars of Investing focuses on risk and reward, and shows through many, many historical examples that risk is heavily tied to reward. For example, if you compare the stock market and the bond market, the stock market has had many, many more individual losing years since 1900 – but the overall gains of the stock market blow away that of the bond market. Why? The stock market is incredibly risky in the short term.

However, you can get around that risk very cleverly. Simply hold the stocks for a very long time. Over a long period (say, 30 years), the risk in the stock market is drastically reduced. In fact, the longer you hold stocks, the lower the risk of a loss is and the greater the potential gain. Along those same lines, one shouldn’t buy too much into those amazing long term gains that the United States stock market has shown over the last hundred years. More and more people have moved into the stock market, creating the fuel for the rocket ride the market has taken (more and more buyers), but there is an upper limit to the number of buyers and eventually those long-term gains won’t be as stratospheric.

Chapter 2 – Measuring the Beast
In terms of intellectual food for thought for an investor, this is one of the meatiest chapters I’ve ever read and still been able to finish. It focuses on how one can figure out whether or not something you buy will have long term value. This is not an easy thing to assess, and this chapter shows why.

In a nutshell, Bernstein shows that anything you buy will increase in value in only one of two ways: it pays you for holding it (in the form of dividends), or the demand for it increases. This goes for stocks, but it also goes for any other investment – gold, for example, doesn’t pay any dividends, so it’s entirely based on demand. In the end, Bernstein says that a smart investor should not have more than 80% of their money in stocks right now. Why? Stock prices are at historical highs and they are paying historically low dividends, which means either the stock market will slow down or it will perpetually push into territory not seen since 1929.

Chapter 3 – The Market Is Smarter Than You Are
This is basically a thirty page compression of the material found in A Random Walk Down Wall Street, and it comes to much the same conclusion as Malkiel’s book. The stock market is too random to effectively manage and time in the short term.

In effect, if you take all of the mutual fund managers out there and average their returns, you get the same return as the broad stock market. Then subtract their pay, and you get an overall return significantly below the broad stock market. So, why not just bypass all of this and invest in the broad stock market as a whole without the managers? That’s what it means to invest in an index fund.

Chapter 4 – The Perfect Portfolio
So what can one do with this information? Buy index funds, of course. Here, Bernstein talks about specifically what to buy.

First of all, every portfolio should have at least 20% of the assets in riskless assets like bonds and so forth. This is to provide stability from the year to year chaos of stocks. This does not hold true, however, if you’re not touching the portfolio at all over the long haul.

Second, the portion that is risky should include foreign stocks and real estate. Foreign stocks should make up 30% to 40% of your risky portfolio, while real estate should be 10% to 15% of your portfolio.

Given the overall recommendation of indexing, I tried to create a Bernstein-approved portfolio based on Vanguard index funds. This is a four-fund strategy that matches the ideas that Bernstein delivers in the first four chapters of the book.

Chapter 5 – Tops: A History of Manias
From there, The Four Pillars of Investing gets into some very interesting topics. Here, the book covers several manias throughout history, but it sticks to ones directly related to stocks, leaving out the endlessly entertaining (to me, anyway) tulip obsession of 1637.

What’s the point? When a few people make a lot of money, many, many people want to jump on board – often to their own detriment. Every time there is a “bubble” – like the recent dot-com bubble and the housing market bubble – it’s the result of a small handful of people making good money and lots of people trying to follow in the footsteps.

Chapter 6 – Bottoms: The Agony and the Opportunity
On the other hand, there are times when everyone jumps out of particular investments, even when the fundamental value of that investment hasn’t really changed that much. Think of the 1930s, where most of the large companies in the United States were doing just fine but the stock market was in tatters. Or the dot-com blowup, which caused the whole market to sag, even sectors that had nothing to do with the overinvesting. Over the long haul, appropriate values do return to these areas.

What does that mean for you as an individual investor? It’s a lot more profitable for an investor to put money in when the market is low than when it’s high. In other words, the best time to buy stocks (in the broad sense of the word) is when everyone else is running away from them.

Pillar Three: The Psychology of Investing

Chapter 7 – Misbehavior
This portion of The Four Pillars of Investing focuses on human behavior and the psychological mistakes we tend to make while investing. What it boils down to is that human nature and instinct – things like a tendency to follow the leader, see patters where there are none, and a need for entertainment – lead us to buy high, sell low, and trade frequently, all of which are dangerous behaviors for investors.

My favorite of the behavioral mistakes described here was the “country club effect,” something I’ve actually witnessed. Basically, people who are susceptible to this are well off and try to make investment moves that compare socially with the people at the country club. In other words, they put their money into unregulated hedge funds so they can brag at the club, while their money would be much better off with Vanguard.

Chapter 8 – Behavioral Therapy
So what can you do to avoid these mistakes? The advice basically boils down to a small number of points.

First, ignore – and even avoid – what everyone else is doing. If everyone is buying, ignore it. If everyone is selling, ignore it (and maybe buy).

Second, don’t be overconfident in your skill or knowledge. You’re combating professionals with a lot more assets to use for leverage, a lot more training in the market, and all the time in the world to beat you. Unless you’re a genius, you won’t win.

Finally, be boring. Don’t make any moves unless they’re planned out carefully. If you need to be entertained, don’t make the stock market your jester unless you’re actually viewing your investments as pure entertainment.

Pillar Four: The Business of Investing

Chapter 9 – Your Broker Is Not Your Buddy
If you’ve read The Simple Dollar much, you know that I never recommend a stockbroker, instead telling people to do it themselves. Why? A stockbroker basically sells you the stuff you can get directly from the source and takes a nice healthy cut for being the middleman.

If you want to buy stocks, buy them yourself through a low-fee brokerage like Scottrade, where the costs to you are low and clear and very upfront. If you want to buy mutual funds, go straight to the company selling them – I do my business with Vanguard.

In a nutshell, a stockbroker makes money off of people with money to invest and no intelligence or inclination to do it themselves.

Chapter 10 – Neither Is Your Mutual Fund
What about mutual funds? Most funds operate in the same way that stockbrokers do – they offer you a product you can get cheaper elsewhere and keep the difference for themselves. For example, many funds will take 2% off the top of what you put into the fund and uses that for marketing and paying for the person who manages your fund.

Thankfully, some mutual fund companies have adopted indexing strategies, where very simple rules dictate what stocks they buy for their fund. They basically eschew most advertising and much of the administrative cost. Fidelity and Vanguard are tops in this category – look to them directly for places to put your investing dollar.

Chapter 11 – Oliver Stone Meets Wall Street
What these advisors are really selling is a false sense of security in a stock market that seems dizzyingly complex. The truth is that it’s not really all that complex, at least not in the terms that an individual investor needs to know about. Bernstein recommends two things that any individual investor should focus on and practice.

First, educate yourself – but not in the sense of watching CNBC. Instead, dig into a real investing book like A Random Walk Down Wall Street (or this one) and read through it slowly, 15 to 20 pages at a time, then think about the reading. This is far more educational and useful than watching Jim Cramer scream and throw chairs for half an hour.

Second, practice discipline. It takes discipline to invest well and resist the temptation to make behavioral mistakes. Basically, practice keeping your hands off your investments and think very carefully about the moves you’re making.

Investment Strategy: Assembling the Four Pillars

Chapter 12 – Will You Have Enough?
The final portion of this book seeks to tie together the four pillars and use them as a basis for an investment plan. This chapter offers much of the basic advice on how to invest.

Guess what? Bernstein’s biggest advice for investors is be frugal and curb your material desires. I agree – frugality is the basis of any sensible personal finance plan. Another key tip: you should accumulate a big enough portfolio so that when it supports you, you only eat about 3.5% of it a year. In other words, take what you want to have annually and multiply it by about 30 – that’s what you need to support yourself in later life and in retirement.

Chapter 13 – Defining Your Mix
This chapter gets very specific about the asset allocations discussed in chapter four, reiterating the same general advice and giving some specific portfolios for examples. I actually found this chapter to be overly complex for most people, as the advice given late in chapter four will suffice.

It is worthwhile to note that Bernstein is very conservative with his investing. He basically says that no one should have less than 20% of their investments in bonds, far more conservative than most people who discuss investments. My own portfolio is 10% bonds and that has been criticized by some.

Chapter 14 – Getting Started, Keeping It Going
So how does one get started? Bernstein basically says one should research a portfolio carefully, figure out their plan, then get started as soon as possible. He recommends doing it through value averaging – in other words, buying into each piece slowly over time. This works perfectly for us poorer investors who don’t have a lump sum with which to invest – we can buy in slowly naturally through a steady automatic plan.

Once the money’s in, you should only rebalance through the use of additional contributions. If you decide to change your allocations, again, do it with new contributions, not by moving money around – that’ll just hurt you on taxes.

Buy or Don’t Buy?

I really enjoyed this book. If you really want to understand the logic and reasoning behind investing choices, carried from the very foundations of how specific investments work all the way to an investment plan you can follow, this is a book well worth reading.

One big note, though: Bernstein is very conservative in his investment choices, both in terms of what you should invest in and how much you should have when you retire. If you follow his advice, you’ll be in very good shape when you retire, but it will take some serious work to get there, both in terms of being diligent and in terms of frugality. Also, be aware that this book can be complex and intellectually challenging, especially in the first part.

Still, if you’re serious about investing and want a nuanced explanation of investing, particularly from a fairly conservative perspective, this book will be an invaluable and educational read.

Bernstein’s other book, The Intelligent Investor, is also very good, but much more dense and econ-like.

In case you are looking for a book recommendation, you should really check out “All About Asset Allocation” by Richard Ferri. It gives an EXTREMELY good explanation of how to go about deciding the right asset allocation for you. Ferri, too, focuses on index funds and ETFs, and also discusses the size/style dimension of stocks very well.

I’ll look for it at the library. I don’t know if I plan to follow his advice, I rather like the Couch Potato portfolio, but I think it’d be a valuable chance to learn more about investing and actually understand! Thanks for sharing.

I had lunch with Bernstein once; he’s a sharp guy and I loved the Four Pillars (the lunch was with a small group of investing enthusiasts).

Trent, regarding your note at the bottom: it’s true Bernstein falls on the more conservative end of the spectrum. His advice is far more responsible than most authors/financial companies who treat the stock market as a sure thing over the long haul.

But, if investment returns are disappointing for the next three to four decades, there are going to be a lot of broken dreams…and people scrambling to make up for lackluster returns. On the other hand, if returns are great. Then investors who have been taking the more “conservative” approach can slow their contributions down or they can choose to retire early.

@ Oswegan – Dave Ramsey is great when it comes to aggressively pursuing success and kicking debt out of your life. However, he presents an overly simplistic view of stock market returns (he acts like the stock market will always offer high returns over the long haul and (on his show at least) he ignores the impact of inflation on investment returns).

Bernstein definitely offers a more complex and safer asset allocation than the KISS breakdown you described. Wading through Four Pillars will take more work than reading a Dave Ramsey book, but you’ll have a better understanding of the investing challenges the younger generations face.

Oswegan, thanks for the response. It’s good to hear that he talks about inflation in his books. I haven’t read any yet, but I have been listening to his show at least a couple of times a week for several months (mostly for research…)

The problem with advocating mutual funds that **have averaged** 10-12% returns is the old saying that previous performance doesn’t guarantee future performance… Lots of funds have done well, especially considering the strong stock market returns for the past couple of decades. So a lot of bad mutual funds would qualify.

I’d be a lot happier if he emphasized the importance of “index funds” which solve a couple of major investing challenges (namely bad management and higher expense ratios). I think I remember hearing index funds discussed on his show a couple of times which isn’t enough considering their importance.

Bernstein discusses the problem with 10-12% expectations in his Four Pillars book. One of the key problems with this expectation is that it ignores how the rising price to earnings ratio (P/E) has affected stock returns.

The price to earnings ratio simply describes how much money investors are willing to pay per dollar of after tax earnings. For example, a P/E of 20 means investors are willing to pay $20 for $1 in earnings (a 5% return).

As Bernstein explains, (disclaimer: I’m operating from memory, my copy isn’t handy) the past few decades have seen investors become increasingly willing to pay more per dollar of earnings. In the past, companies have sold at P/Es of 10 and even lower. Now the average is much higher, let’s say 20.

So, in order to see 10-12% returns, people are going to either (1) be willing to pay even higher prices for few dollars in earnings, (2) companies will need to be significantly more profitable to warrant higher prices (so the P/E will stay the same or drop), or (3) the market will need to experience a major correction to set the stage for big returns again.

I’m not trying to belittle Dave Ramsey. I have great admiration for him and his advice. However, Dave’s advice is more of a starting point rather than a final destination (although one could do much worse)…

I agree with the idea that Dave is a great starter (getting people motivated to get debt free) but maybe not the best finisher (investment advice). I’ve found it to be really useful to get a lot of input from a lot of different financial books to get a broad picture of how things work.

Trent, I would go one step further and say reading many investing books from different perspectives is *essential* if one wants to be on track for success.

Like most things in life, sorting the truth from half-truths becomes easier the more one reads. For example, how long do most investors have to search before discovering that beating the market really isn’t possible? Billions are made on investments and books/magazines arguing the exact opposite!

hello sir
i’m 48 years old and e-5 in the military(ARMY)and do have the TSP saving plan. Do you know about this TSP. Mr. Ramsey has taken the fear out managing my money. My children Valerie 11 and David 9 has had to do a budget for the last 2 years or so. David writing was pretty bad, but he did it. We love Dave. Anyway, can you tellme more about what i need to do. I have a Fidelty Destiny 2 account that I bought from USAPA IRA(old name) the new name is Frist Command Bank.

Books worth budgeting for

My new book, The Simple Dollar: How One Man Wiped Out His Debts and Achieved the Life of His Dreams, is available in bookstores now. Check out some of the life-changing experiences the book has given readers!

Check out my book, 365 Ways to Live Cheap, available in bookstores everywhere! It's filled with 365 great tactics you can apply to your personal finances, from frugal tips to great ideas for managing your money.